Principles of Macroeconomics

class: center, middle, inverse, title-slide

.title[
# Principles of Macroeconomics
]
.author[
### ECO 2307
]
.date[
### <em>Spring 2023</em>
]

---

class: center, middle, inverse

# Chapter 14
## Money, Banks, and the Federal Reserve System

---

## Money
.panelset[
.panel[.panel-name[Money]
.left-column[
<br>
<br>

![](data:image/png;base64,#images/ch_14/bluey_dollar_bucks.gif)
]
.right-column[
#### What is money?
- Important invention
  - Asset accepted in exchange for goods and services or for payment of debts
  - Assets are things of value owned by people or firms
- Money serves a role in exchange
  - Banks and governments create and manage modern forms of money
- Model created relating prices to the amount of money

#### Why do we need money?
- Trading without money requires bartering
- Commodity money used in societies for trading
- Money makes trading easier and allows specialization
]

]
.panel[.panel-name[4 Functions]
### The Four Primary Functions of Money
.pull-left[
**1. Medium of exchange:** form of payment for goods and services

**2. Unit of account:** Money allows a way of measuring value in a standard manner

**3. Store of value**
- Can defer consumption by storing value
- Not unique in this, but money is good at it because *liquid*

**4. Standard of deferred payment**
- Facilitates exchange across time
- Predictable purchasing power
]
.pull-right[
![](data:image/png;base64,#images/ch_14/thats_what_the_money_is_for.gif)
]
]
.panel[.panel-name[Media of Exchange]
### What Can Serve as Money?
.pull-left[
Acceptable media needs certain characteristics:
1.	Acceptable to most people
2.	Standardized quality
3.	Durable
4.	Valuable relative to its weight
5.	Divisible enough to be used for purchases of both low-priced and high-priced goods
]
.pull-right[
![](data:image/png;base64,#images/ch_14/what_are_we_going_to_do_for_money_now.gif)

]
]
.panel[.panel-name[Commodity]
### Commodity Money
.pull-left[
Commodity money has a value independent of its use as money

Some important historical and modern commodity moneys:
- Cowrie shells in Asia (the classical Chinese character for money/currency, originated as a pictograph of a cowrie shell)
- Precious metals, such as gold or silver
- Animal pelts and skins in colonial North America
- Cigarettes in prisons and prisoner-of-war camps
]
.pull-right[
![](data:image/png;base64,#images/ch_14/cowrie_shells.png)
]
]
.panel[.panel-name[Fiat]
.pull-left[
### Paper Money to Fiat Money
Began 10th century China
- paper money issued by banks/governments
- exchangeable for some commodity (i.e. gold) on *demand*

Modern economics
- typically issued by central bank 
  - i.e. government bank
  - Federal Reserve is US central bank
- Paper money not exchangeable for gold or other commodities anymore

]
.pull-right[
### Fiat Money—Advantages and Disadvantages
Advantages
- governments do not have to be willing to exchange it for gold or some other commodity on demand
- central banks more flexible in creating money

Disadvantages
- fiat money is only acceptable as long as households and firms have confidence
- if people stop “believing” in the fiat money, it will cease to be useful
]
]
.panel[.panel-name[Wizard of Oz]
.pull-left[
**Gold standard (industrialists)**
- tied the value of national currency to gold
- backed by gold
- "gold bugs" thought gold would 
  - keep dollar stable
  - maintain competitive marketplace
  - promote economic liberty

**Silver standard (farmers)**
- money backed by silver and gold
- Silver more easily accessible
- allows more flexible money supply
- "Silverites" thought this would lead to
  - fairer economy
  - better social reforms
]
.pull-right[
**Wizard of Oz and the Gold/Silver Standard**

**Film based on L. Frank Baum novel (1900)**
- possibly an allegory about the gold standard
- Yellow-brick road leads to Emerald city
- Silver shoes take you back to farm

]
]

]

---

## How Is Money Measured in the United States Today?
.panelset[
.panel[.panel-name[Money Supply]
### How much money is there in the U.S.? 
- Difficult to say--need to define "money"
- M1 
  - *narrow definition* of the money supply
  - sum of currency in circulation *and* checking accounts *and* savings accounts deposits
- M2 
  - *broader definition* of the money supply
  - includes M1, plus small-denomination time deposits, and noninstitutional money market fund shares

]
.panel[.panel-name[M1 vs. M2]
### M1 versus M2: Which One Should We Use?
.pull-left[
- Both are valid
  - mostly we're interested in role as medium of exchange
  - so, tend to prefer M1

- Thus, we:
1. Treat currency, checking account balances, and savings account balances as “money” but nothing else
2. Realize that banks play an important role in the money supply
  - they control what happens to money (checking/savings account)
]
.pull-right[
<img src="data:image/png;base64,#images/fig_14_1.png" width="100%" style="display: block; margin: auto;" />
]
]
.panel[.panel-name[Debit/Credit Cards]
### Are Debit and Credit Cards Money?

#### Debit cards directly access checking accounts

#### Credit cards are short-term loans from issuing bank

Take a couple of minutes and discuss with your classmates

]
.panel[.panel-name[]

]

]

---

## How Do Banks Create Money?
.panelset[
.panel[.panel-name[Banks' Role]
.pull-left[
Banks 
- play a critical role in the money supply
  - More money is held in checking accounts than there is actual currency in the economy
  - So, somehow money is being created by banks
- generally profit-making private firms
  - some small, but some among the largest corporations in the country
- activities are designed to make a profit

]
.pull-right[

To understand the role that banks play, we will first consider how banks operate as a business

![](data:image/png;base64,#images/ch_14/banks_role.png)

]
]
.panel[.panel-name[Balance Sheet]

.pull-left[
**The Balance Sheet of a Typical Large Bank**

**Banks**
- use deposits to make loans and buy securities (investments)
- largest liabilities are **deposit accounts:** money they owe to their depositors

**Reserves**
- deposits that bank keeps as cash on hand (vault) or on deposit (Fed)
- bank does not keep enough deposits on hand to cover all of its deposits
- this is how the bank makes a profit: lending out or investing money deposited with it
]
.pull-right[
<img src="data:image/png;base64,#images/fig_14_2.png" width="100%" style="display: block; margin: auto;" />
]

]
.panel[.panel-name[Reserves]
**Bank must keep some cash available for its depositors**
- vault cash
- deposits with Federal Reserve

.pull-left[
**Required reserves**
- US banks must hold **required reserves** based on its checking account deposits
- **required reserve ratio (RR):** minimum fraction of deposits banks are required by law to keep as reserves
- Before March 2020
  - RR was 10%
- After March 2020
  - 0% of checking account deposits
  - No plans to reinstate reserve requirements
]
.pull-right[
**Excess reserves**
- Banks might choose to hold **excess reserves**
- **excess reserves**: reserves that banks hold over the legal requirement
]
]
.panel[.panel-name[]
### Help for Young Borrowers: Fintech or Ceilings on Interest Rates?
In recent years, some new financial technology or fintech companies—such as LendingClub and FreedomPlus—have emerged to offer peer-to-peer lending on the Internet.
These firms earn flat fees for facilitating a loan and charge fees for collecting payments but take none of the risk of the loans defaulting.
Will these firms facilitate too many risky loans? Early evidence suggests “yes.”

U.S. Senators Sanders and Ocasio-Cortez have introduced legislation to address the problem of access to credit. 
They want to cap credit card interest rates at 15%.
Banks are the primary issuers of credit cards and argue the cap would simply result in many people with poor credit scores not having access to credit. 
Recall that price ceilings result in shortages and in the case the price of money is the interest rate. Riskier borrowers would not be issued credit cards by most lenders.
As of mid-2021, it looked like this legislation wouldn’t pass but it may emerge again in the future.
]
.panel[.panel-name[Money Creation]

.pull-left[
**T-account**
- is a stripped-down version of bank balance sheet
- shows only how a transaction changes a bank’s balance sheet

**Example: Deposit $1,000 at BoA**
- BoA's reserves increase by $1,000 and so do its deposits
- Currency component of money supply decreases by $1,000 (removed from circulation)
- But checking deposits component increases by $1,000
- So, *no change* in money supply (yet)

]
.pull-right[
<img src="data:image/png;base64,#images/ch_14/boa_ex_a.png" width="100%" style="display: block; margin: auto;" />

**Now BoA needs profit**
- So it keeps 10% of deposit as reserves and lends out the rest
- This creates a $900 checking account deposit
- This loan increases money supply to $1,900
]
]
.panel[.panel-name[Follow the $]
.pull-left[
#### Follow the Money
- $900 initially appears in BoA checking
- Quickly transferred to bank where deposited (PNC)
- PNC continues the cycle

#### PNC Bank Continues
- Loans out $810 in excess reserves
- new checking deposit of $810
- money supply now: $1,000 + $900 + $810 = $2,710
- money supply increased by $2,710-1,000 - $1,710
]
.pull-right[
<img src="data:image/png;base64,#images/ch_14/boa_ex_b.png" width="100%" style="display: block; margin: auto;" />

<img src="data:image/png;base64,#images/ch_14/boa_ex_c.png" width="80%" style="display: block; margin: auto;" />
]
]
.panel[.panel-name[When Will It End?]
### When Will It End?
.pull-left[
Each round, the additional checking account deposits get smaller and smaller
- Every round, 10% of the deposits are kept as reserves 
- Eventually, $1,000 in currency will become the 10% RR for all checking deposits
- So, a total of $10,000 in checking deposits can be created 
$$
\frac{1000}{0.10}=10,000
$$
]
.pull-right[
![](data:image/png;base64,#images/ch_14/skip_to_the_end.gif)
]
]
.panel[.panel-name[Deposits Multiplying]
.pull-left[
<img src="data:image/png;base64,#images/ch_14/deposits_multiplying.png" width="100%" style="display: block; margin: auto;" />
]
.pull-right[
<img src="data:image/png;base64,#images/ch_14/when_will_it_end.png" width="100%" style="display: block; margin: auto;" />
]
]
.panel[.panel-name[Simple Deposit Multiplier]
### Simple Deposit Multiplier
So, the total increase in deposits is $1,000(10)=$10,000
- the “10” is the *simple deposit multiplier*
- **simple deposit multiplier:** the ratio of the amount of deposits created by banks to the amount of new reserves

In general, we can write the *simple deposit multiplier* as:

$$
\textit{Simple Deposit Multiplier} = \bigg(\frac{1}{RR}\bigg)
$$

So if RR = 10%, the simple deposit multiplier = 10

]
.panel[.panel-name[Simple vs. Real World Multiplier]
### Simple Deposit Multiplier versus Real-World Deposit Multiplier
.pull-left[
#### Expect 10X multiplier
With a 10 percent required reserve ratio, 
- the simple deposit multiplier tells us that a currency deposit will be multiplied 10 times

But in the real world, we do not observe this: 
- currency deposits only end up being multiplied by less than 2
- In April 2021, the multiplier was less than 1
]
.pull-right[
#### Why this difference?
- Banks may not lend out as much as we predict
  - because they want to keep excess reserves, or 
  - they cannot find credit-worthy borrowers
- Consumers keep some currency out of the bank
  - this can't be used as required reserves

Note: During the recession of 2007-2009, research suggests that the real-world multiplier also fell to less than 1
]
]
.panel[.panel-name[Conclusions]
### Conclusions about Banks and the Money Supply
.pull-left[
In general, we can assume that the real-world deposit multiplier is greater than 1.

So, we conclude that:

1.	When banks gain reserves, 
  - they make new loans, and 
  - the money supply expands
2.	When banks lose reserves, 
  - they reduce their loans, and 
  - the money supply contracts

So this is how banks and money supply interact.
]
.pull-right[
![](data:image/png;base64,#images/ch_14/banks.gif)
]
]
]

---

## The Federal Reserve System
.panelset[
.panel[.panel-name[Intro]
.pull-left[
<p align="center">
<iframe width="550" height="315" src="https://www.youtube.com/embed/xE5klz0yUT0" title="Mary Poppins – Bank Run" frameborder="0" allow="accelerometer; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen></iframe>
</p>
]
.pull-right[
#### Consumer Confidence
- Recall, in the US, banks keep less than 100% of deposits as reserves
  - this is a **fractional reserve banking system**
  - it’s a system shared by nearly all countries
- But what if a bunch of depositors lose confidence all at once?
  - Try to withdraw their money all at once
  - **Bank run**
- If many banks experience bank runs at the same time, a **bank panic** occurs
]

]
.panel[.panel-name[Panic]
.pull-left[
#### The Feedback Loop During a Bank Panic
- Central banks, like the Federal Reserve, can help to prevent bank runs and panics 
  - Act as a *lender of last resort*
  - promising to make loans to banks in order to pay off depositors
- This assurance can break the negative feedback loop
]
.pull-right[
<img src="data:image/png;base64,#images/fig_14_3.png" width="80%" style="display: block; margin: auto;" />
]
]
.panel[.panel-name[The Fed]
### The Establishment of the Federal Reserve System
.pull-left[
**Late 19th and early 20th centuries**
- Several bank panics
- 1914, the Federal Reserve system started.

**“The Fed” **
- makes loans to banks 
  - called **discount loans**
  - charge a rate of interest called the **discount rate**
]
.pull-right[
**1930s (Great Depression)**
- Many banks were hit by bank runs
- Over 5,000 banks failed b/c Fed refused loans
- Today: many econs think Fed was wrong in '30s

**Response to the Great Depression**
- Establish FDIC in 1934 to limit bank panics
- Insure up $250,000
- Bank runs are still possible
  - 2007-2009, a few banks experienced runs from large depositors whose deposits exceeded the FDIC limit
  - This is the concern with regional banks
]
]
.panel[.panel-name[...]
.pull-left[
In 1913, Congress divided the country into 12 Federal Reserve districts, each of which provides services to banks in the district.

But the real power of the Fed lies in Washington DC, with the Board of Governors.
In 2017, the chair of the Board of Governors was Janet Yellen.

Meeting 8 times per year, the **Federal Open Market Committee (FOMC)** is responsible for open market operations and managing the money supply in the United States.
]
.pull-right[
### The Federal Reserve System 
<img src="data:image/png;base64,#images/fig_14_4.png" width="80%" style="display: block; margin: auto;" />
]

]
.panel[.panel-name[Managing Supply]
.pull-left[
### How the Federal Reserve Manages the Money Supply
Fed established to stop bank panics

Now it manages money supply via **monetary policy**
- monetary policy: actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic objectives
- Uses six monetary policy tools
]
.pull-right[
### The Fed’s Six Monetary Policy Tools
1.	Open market operations
2.	Discount policy
3.	Reserve requirements
4.	Interest on reserves
5.	Overnight reverse repurchase agreement facility
6.	Term deposit facility
]
]
.panel[.panel-name[Main Fed Tool]
.pull-left[
#### Open Market Operations
- The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply.

Increase money supply

- the Fed's NY trading desk purchases U.S. Treasury securities
- Treasury bills, notes, and bonds, which are tradeable loans to the U.S. Treasury

Decrease money supply

- the Fed sells its securities—an open market sale
- can occur very quickly and are easily reversible
]
.pull-right[
#### Open Market Operations in Action
Suppose the Fed engages in an open market purchase of $10 million.
- Banking system T-account
  - increase reserves
  - decrease assets
- Fed: 
  - banking system's reserves are liabilities
  - gains assets equal to debt owed by banking system
]
]

.panel[.panel-name["Old" Tools]
#### Discount policy
- **discount rate:** interest rate paid on money banks borrow from the Fed
- `$\downarrow$` discount rate => banks borrow/lend *more* => `$\uparrow$` money supply
- Raising the discount rate has the opposite effect

#### Reserve requirements
- Decrease => more loans being made => `$\uparrow$` the money supply
- Increase => `$\downarrow$` loans being made

]
.panel[.panel-name["New" Tools]
#### Interest on Reserves
- 2008, Fed pays interest on required & excess reserves
- Decrease in rate
  - `$\uparrow$` the incentive of banks to make loans rather than hold reserves
  - Banks `$\uparrow$` loans => money supply `$\uparrow$`
- Increase rate on bank reserves for the opposite effect

#### Repurchase Agreements (Repos)
- short-term borrowing/lending agreements backed by collateral
- repurchase aggreements typically overnight

#### Term Deposit Facility (least used by Fed)
- Since April 2010, Fed offers term deposits (like C.D.s)
- Interest rates slightly higher than reserve interest rates
- Using this vehicle reduces funds available to loan

]
]

---
## The “Shadow Banking System” 
.panelset[
.panel[.panel-name[Intro]

Commercial banks primary role 
- accept funds from depositors 
- make loans to borrowers.

In the last 25 years, two important developments have occurred in the financial system:
1.	Banks have begun to resell many of their loans rather than keep them until they are paid off
2.	Financial firms other than commercial banks have become sources of credit to businesses

**Securitization:** process of transforming loans or other financial assets into securities

**Shadow-banking:** raising funds from investors and providing them directly or indirectly to firms and households
]

.panel[.panel-name[Securitization]
.pull-left[
#### Securitization Comes to Banking
**Security**
- a financial asset that can be bought and sold in a financial market
- e.g., a stock or a bond

**Evolution**
- Traditionally 
  - bank keep mortgage loan
  - collect payments until loan payed off
- 1970s
  - secondary markets developed for *securitized loans* 
  - these loans were traded like stocks and bonds
]
.pull-right[
![](data:image/png;base64,#images/ch_14/securitization.png)
]
]
.panel[.panel-name[Process]
### The Process of Securitization
<img src="data:image/png;base64,#images/fig_14_5a.png" width="100%" style="display: block; margin: auto;" />
]
.panel[.panel-name[Shadow Banking]
.pull-left[
- Non-bank financial firms ('90s and '00s)
- **Investment banks**
  - Not household deposits/loans
  - Provide investment advice 
  - Engage in creating/trading securities (e.g., mortgage-backed securities)
- **Money market mutual funds**
  - Sell shares to investors 
  - Use the money to buy short-term Treasury bills and commercial paper 
  - Buying commercial paper serves as loans to corporations
- **Hedge funds**
  - Raise money from wealthy investors 
  - Make “sophisticated” investments
  - Often non-standard, high-risk investments
]
.pull-right[
![](data:image/png;base64,#images/ch_14/shadow_banking.png)
]

By raising funds from investors and providing them directly or indirectly to firms and households, these firms have become a “shadow banking system.”

]
.panel[.panel-name[Great Recession]
### The Financial Crisis of 2007-2009
<p align="center">
<iframe width="550" height="315" src="https://www.youtube.com/embed/-DT7bX-B1Mg" title="And it&#39;s gone (original)" frameborder="0" allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen></iframe>
</p>
]
.panel[.panel-name[...]
.pull-left[
#### What made this “shadow banking system” different from commercial banks?
Shadow banks less-regulated (not FDIC-insured)
- Highly leveraged
  - Rely heavily on borrowed money
  - Investments inherently riskier

Especially vulnerable to runs
- Beginning in 2007
- Housing prices `$\downarrow$` => `$\uparrow$` => value of mortgage-backed securities `$\downarrow$`
- Highly leveraged firms experienced large losses
- Some went bankrupt
]
.pull-right[
#### The Fed’s Response
The Fed (and U.S. Treasury) responded
- Modified its discount policy, granting loans to previously ineligible financial firms
- Bought commercial paper for the first time since the 1930s
- Similar response in the Covid-19 recession

These and other actions eventually stabilized the financial system, though it took several years for the flow of funds from savers to borrowers to return to normal levels.
]
]
]

---

## The Quantity Theory of Money
.panelset[
.panel[.panel-name[Background]
.pull-left[
#### Connecting Money and Prices
Beginning in the sixteenth century, Spain sent gold and silver from Mexico and Peru back to Europe.
- These metals were minted into coins, increasing the money supply.
- Prices in Europe rose steadily during those years.
- This helped people make the connection between the amount of money in circulation and the price level.
]
.pull-right[

]
]

.panel[.panel-name[Quantity Equation]
.pull-left[
### The Quantity Equation
Irving Fisher (1920s?) formalized relationship between money and prices:

$$
M \times V=P \times Y
$$

- `$M$`: Money supply
- `$V$`: **Velocity of money**
  - average number of times each dollar in the money supply is used to purchase goods and services included in GDP
- `$P$`: Price level
- `$Y$`: Real output
]
.pull-right[

### Velocity

Rewriting the quantity equation by dividing through by `$M$`, we obtain:

$$
V = \frac{P \times Y}{M}
$$
]
]
.panel[.panel-name[Velocity]
.pull-left[
### Calculating Money Velocity
Measuring the:
- Money supply `$(M)$` with M1,
- Price level `$(P)$` with the GDP deflator, and
- Level of real output `$(Y)$` with real GDP, 
- So `$P \times Y$` is **nominal GDP**

We obtain velocity `$(V)$` in 2020:

$$
V = \frac{\text{\$18.4 trillion}}{\text{\$12.9 trillion}}=1.4
$$
]
.pull-right[
### Quantity Theory of Money
Is `$V$` always the same?
- Yes, subject to measurement error according to quantity theory of money
- **Quantity theory of money:** a theory about the connection between money and prices that assumes that the velocity of money is constant
]
]
.panel[.panel-name[Inflation]
<p align = "center">
<iframe width="688" height="387" src="https://www.youtube.com/embed/gi7jx5IJtik" title="Causes of Inflation" frameborder="0" allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen></iframe>
</p>
]
.panel[.panel-name[Inflation 2]
### The Quantity Theory Explanation of Inflation
When variables are multiplied together in an equation, we can form the same equation with their growth rates added together.
- So, the quantity equation, `$M \times V = P \times Y$`
- generates:

$$
`\begin{equation}
(\textit{Growth rate of the money supply} + \textit{Growth rate of velocity}) \\
= \\
(\textit{Growth rate of the price level (or the inflation rate)} + \textit{Growth rate of real output})
\end{equation}`
$$

Solve for inflation rate (assume `$V=0$`)

$$
\textit{Inflation rate} = \textit{Growth rate of the money supply} - \textit{Growth rate of real output}
$$
]
.panel[.panel-name[Inflation 3]
### The Inflation Rate According to the Quantity Theory
This equation provides the following predictions:
1.	If the money supply grows faster than real GDP, there will be inflation.
2.	If the money supply grows slower than real GDP, there will be deflation (a decline in the price level).
3.	If the money supply grows at the same rate as real GDP, there will be neither inflation nor deflation: the price level will be stable.

Is velocity truly constant from year to year? 
- The answer is no.
- But the quantity theory of money can still provide insight:
- In the long run, inflation results from the money supply growing at a faster rate than real GDP.
]
.panel[.panel-name[Money Growth and Inflation]
.pull-left[
**United States**
<img src="data:image/png;base64,#images/fig_14_6a.png" width="80%" style="display: block; margin: auto;" />
]
.pull-right[
**Other Countries**
<img src="data:image/png;base64,#images/fig_14_6b.png" width="85%" style="display: block; margin: auto;" />
]
]
.panel[.panel-name[Hyperinflation]
### High Rates of Inflation
.pull-left[
- **Hyperinflation**
  - Very high rates of inflation
  - in excess of 50 percent per month
  - Associated with slow growth, if not severe recession
- Results when 
  - central banks `$\uparrow$` money supply way faster than real GDP grows
  - e.g., governments spend much more than taxes
  - so central bank “buys” government bonds
]
.pull-right[
**Examples**

Zimbabwe (2000s)
- Prices increased by more than 10,000% per year
- Can of soda costing $1 this year would cost 
  - over $100 next year 
  - over $10,000 the year after that
- inflation rate reached 15 billion % in 2008

Venezuela (2009): inflation rates over 2 million %

]
]

]